Keynes’ asset management: King’s College, 1921–1946: The British origins of the US endowment model

David Chambers, Elroy Dimson20 October 2014

Yale University has generated annual returns of 13.9% over the last 20 years on its endowment – well in excess of the 9.2% average return on US university endowments. Keynes’ writings were a considerable influence on the investment philosophy of David Swensen, Yale’s CIO. This column traces how Keynes’ experiences managing his Cambridge college endowment influenced his ideas, and sheds light on how some of the lessons he learnt are still relevant to endowments and foundations today.

In recent years much attention has been given to the so-called ‘Yale model’, an approach to investing practised by the Yale University Investments Office in managing its $24 billion endowment. The core of this model is an emphasis on diversification and on active management of equity-orientated, illiquid assets (Yale 2014). Yale has generated returns of 13.9% per annum over the last 20 years – well in excess of the 9.2% average return on US college and university endowments. Other leading US university endowments have followed this model (Lerner et al. 2008). Many other types of investors have thought to adopt this model, either in part or in whole.

David Swensen, Yale’s CIO, quotes John Maynard Keynes extensively in his excellent book Pioneering Portfolio Management. It is clear that Keynes’ writings were a considerable influence on Swensen’s investment philosophy. The key ideas that he takes from Keynes are:

The futility of market timing (Swensen 2009: 64);

The benefits of a value approach (Swensen 2009: 89);

The attractions of being a contrarian (Swensen 2009: 92);

Bottom-up security selection (Swensen 2009: 188); and

The great difficulties inherent in group decision-making, which push an investment organisation towards a situation where “it is better for reputation to fail conventionally than to succeed unconventionally” (Swensen 2009: 298).

A natural question which arises at this point is from where did Keynes gain these insights? Our study of Keynes’ experiences managing his Cambridge college endowment sheds light on how some of the lessons he learnt are still relevant to endowments and foundations today (Chambers et al. 2014).

Keynes managed the endowment of King’s College, Cambridge from 1921 until his death in 1946, and his appreciation of the attraction of equities to long-horizon investors proved to be his great investment innovation (Chambers and Dimson 2013). As Figure 1 illustrates, the King’s College endowment ignored equities in favour of real estate and fixed-income securities up to 1920. As soon as Keynes took over the management of the endowment he set about selling off a substantial portion of the real estate portfolio in order to reallocate these funds to equities. Upon Keynes’ death, the College had reached a one-third allocation to this new asset class. No other Oxford or Cambridge college endowment followed Keynes’ lead. Even the Ivy League endowments – far less restricted by statute as to the choice of investments – were slower to make a similar move (Goetzmann et al. 2010). King’s continued to allocate to equities for another quarter-century after Keynes’ death, and had 80% invested in public equities by the early 1970s.

Our analysis of the characteristics of his stocks, stock transactions, portfolio turnover, and performance substantiates Keynes’ own writings on the subject cited by Swensen above. Furthermore, his investment experiences during the Great Depression of the 1930s are relevant to modern-day investors having been through the recent Great Recession. He had to discover for himself the difficulty of making profits from market timing when the stock market crashed in 1929. His switch to a more careful buy-and-hold stock-picking approach in the early 1930s allowed him to maintain his commitment to equities when the market fell sharply once more in 1937–1938. His management of his college endowment provides an excellent example of the natural advantages that accrue to such long-horizon investors as university endowments in being able to behave in a contrarian manner during economic and financial-market downturns.

Keynes’ enthusiasm for equities is to be contrasted with his concerns about his endowment’s substantial allocation to real estate – the illiquid asset class of his day. A large allocation to illiquid assets, underpinned by the promise of superior returns to active management, has been one of the main characteristics of the Yale model. However, Keynes was more circumspect about such assets in his day and cautioned the need to understand the true nature of these assets. He warned that:

“Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair grey. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one.” (Keynes 1938: 108)

Keynes was alerting his peers to the fact that the apparent low volatility of real estate returns was not a true reflection of underlying returns when a genuine attempt is made to mark these investments to market. His advice is as relevant to private equity today as it was to real estate in his day. Investors need to receive adequate compensation for the illiquidity risk they take on. Hence, even long-horizon investors should be wary of an over-allocation to such illiquid assets and avoid compromising any shorter-term liquidity requirements (Ang et al. forthcoming). This was advice which one of Yale’s closest competitors, Harvard, failed to heed during the 2008 financial crisis (Munk 2009).

Our research shows that Keynes was an extremely active investor who constructed equity portfolios that exhibited high double-digit tracking error compared to the UK market. Consequently, we are not surprised that he wrote as follows:

“[My] theory of risk is that it is better to take a substantial holding of what one believes in than scatter holdings in fields where he has not the same assurance. But perhaps that is based on the delusion of possessing a worthwhile opinion on the matter.”

At the same time, however, he acknowledged the likelihood that a fully diversified approach might be more suitable for investors not possessing the requisite skill in equity investing, saying that:

“The theory of scattering one’s investments over as many fields as possible might be the wisest plan on the assumption of comprehensive ignorance. Very likely that would be the safer assumption to make.” (Keynes 1945)

This is perhaps the most relevant piece of advice which Keynes had for those endowments and foundations with limited time and resources to devote to asset management. The alternative to an active investment approach is to focus on minimising management costs and to move towards a passive approach. Here again we find Swensen drawing inspiration from Keynes in that his second book on investment management, aimed at the general investor, extolled the virtues of a low-cost, passive approach (Swensen 2005).